The fragility of the banking before the massive withdrawal of deposits

A stable and developed financial system is essential for achieving a healthy economy and a prosperous society. But the banks themselves must enjoy good financial health if they want to contribute to this financial stability and become an integral part of that system.

The banking entities obtain their returns through the capture of money deposits, which have certain characteristics of profitability and liquidity. The bank must manage the liquidity in such a way that the needs are met in order to be able to face the liabilities without incurring high costs, which establishes certain elements of fragility in its own structure in circumstances of distrust or banking panic.

Banking: The most leveraged business in the world

Banking is a very atypical sector, because if we analyze the structure of the weights that make up the Net Equity and the Liability versus the Assets, it does not look like another sector. The most important characteristic of the banking business is its high degree of leverage, that is, borrowed money that is not part of the company itself.

Based on the data provided by the OECD, the ratio between financial assets and their assets in the banking sector in 2015 was 10.9%. As a counterpoint, the United States maintained a ratio of 5.9% and the United Kingdom of 30.3%.

To understand the balance sheet of the sector in more detail, the following table corresponds to the Net Equity and the Liabilities of Santander before the incorporation of Popular. As can be seen, the Net Equity is $ 100,963 million, while its Liabilities is $ 1,212,582 million, which is 8.3% and 91.7% respectively on the bank’s assets.

On the other hand, of the total of the Santander Liabilities, customer deposits total 764,336 million euros, which translates into 63% of the total liabilities of the entity. So in a context of banking panic, this would be the most fragile percentage susceptible to strong variations.

Due to the sector’s great leverage, liquidity management – satisfying the entity’s cash needs – is one of the most important points for the development of banking activity, which includes: withdrawals and non-renewal of deposits by banks. part of their clients and the ability to obtain wholesale financing to make new loans.

Trust, the basic pillar of the banking sector

Modern banks are highly leveraged institutions, and because of this, fractional reserve banking can only succeed in a given context, when lenders in a bank have full confidence in financial strength to meet their obligations as they come due.

The great effort to manage the liabilities of banks is to ensure stability in deposits, which translates into a high degree of permanence in their balance sheet, as well as the cost of these deposits.

Therefore, confidence is probably the most relevant variable when analyzing an entity because it directly affects the sensitivity of deposits. This trust integrates, on the one hand, the confidence in the economic environment that the entity and on the other, the confidence in the entity.

Most of the deposits of an entity are demand deposits, that is, those that the payment can be claimed immediately. And under normal circumstances, banks know that the probability that all their depositors withdraw their money in turn is very low, generating a strong stability component.

To provide a framework of trust, there are various measures such as the Deposit Guarantee Fund (FGD), with annual contributions from the member entities, which allow savers to have their deposits guaranteed (100,000 euros per entity and owner).

If there is no confidence in an entity or in the environment, the stability or permanence of deposits will be besieged. Consequently, the financial balance of the bank, as well as the performance of its activity, will be compromised and can put any entity, regardless of size, into serious difficulties.

Therefore, as we have seen recently in Catalonia, faced with a scenario of political tension and with a high degree of uncertainty about the legal environment, there has been a loss of confidence that translates into the withdrawal of deposits and all this has led to to the entities to a change of social domicile, to provide a message of tranquility and ensure that, in any case, remain under the umbrella of the ECB-lender of last resort.

Banking corralitos, when the panic seizes the depositors

The banking corral is a common feature of extreme crises that have played a prominent role in monetary history. When that basic trust is lost to maintain the banking system, a banking panic is generated, and depositors rush to withdraw their deposits because they distrust the solvency of a specific bank or the entire banking system.

In fact, sudden deposit withdrawals can force the entity to liquidate many of its assets at a loss and go bankrup. The strong weaknesses of banking or bank failures can ultimately lead to a breakdown of the monetary system and a fall in GDP. To avoid this situation, capital controls or corralitos are produced as we have seen in Cyprus and Greece.

Cyprus was the first rescue of international lenders with the condition of imposing losses on bank depositors, a measure considered inconceivable until then. The agreement was followed by the closure of the entire banking sector for almost two weeks with the imposition of capital controls in order to avoid a bank failure.

Greece imposed capital controls at the end of June 2015, in an attempt to avoid a withdrawal of bank deposits and the collapse of its banking sector. As the Greek crisis had deepened and an agreement between Greece and its creditors did not materialize, its banks became the country’s main vulnerability.